Our discussion of the stock market would not be complete without an examination of what we might refer to as "unconventional equities." We lump three types of securities into this category: real estate investment trusts (REITs), master limited partnerships (MLPs), and royalty trusts. These securities trade like stocks but carry important differences, particularly with regard to tax treatment. Let's take a look at the benefits and drawbacks of each security type.

Benefits of REITs

A real estate investment trust (REIT) is a company that owns and manages income-producing real estate. REITs were created by an act of Congress in 1960 to enable large and small investors alike to enjoy the rental income from commercial property. REITs are governed by many regulations, the most important being that they must distribute at least 90% of their taxable income to shareholders each year as dividends; the REIT is permitted to deduct dividends paid to shareholders from its taxable income. Other important regulations include:

Asset requirements: at least 75% of assets must be real estate, cash, and government securities.

Income requirements: at least 75% of gross income must come from rents, interest from mortgages, or other real estate investments.

Stock ownership requirements: shares in the REIT must be held by a minimum of 100 shareholders.

REITs specialize by property type. They invest in most major property types with nearly two thirds of investment being in offices, apartments, shopping centers, regional malls, and industrial facilities. The rest is divided among hotels, self-storage facilities, health-care properties, and some specialty REITs that own anything from prisons, theatres, and golf courses to timberlands.

Some benefits of REITs include:

High Yields. For many investors, the main attraction of REITs has been their dividend yield. The average dividend yield for REITs was about 4.3% in September 2012, well more than the yield of the S&P 500 Index, but pretty far below the longer-term average for REITs, which had been trending in the 7%-8% range (recent REIT popularity has pushed stock prices up and yields down). Also, REIT dividends are secured by stable rents from long-term leases, and many REIT managers employ conservative leverage on the balance sheet.

Simple Tax Treatment. Unlike most partnerships, tax issues for REIT investors are fairly straightforward. Each year, REITs send Form 1099-DIV to their shareholders, containing a breakdown of the dividend distributions. For tax purposes, dividends are allocated to ordinary income, capital gains, and return of capital. As REITs do not pay taxes at the corporate level, investors are taxed at their individual tax rate for the ordinary income portion of the dividend. The portion of the dividend taxed as capital gains arises if the REIT sells assets. Return of capital, or net distributions in excess of the REIT's earnings and profits, are not taxed as ordinary income, but instead applied to reduce the shareholder's cost basis in the stock. When the shares are eventually sold, the difference between the share price and reduced tax basis is taxed as a capital gain.

Liquidity of REIT Shares. REIT shares are bought and sold on a stock exchange. By contrast, buying and selling property directly involves higher expenses and requires a great deal of effort.

Diversification. Studies have shown that adding REITs to a diversified investment portfolio increases returns and reduces risk since REITs have little correlation with the S&P 500.

Drawbacks of REITs

REITs also have some drawbacks, including:

Sensitive to Demand for Other High-Yield Assets. Generally, rising interest rates could make Treasury securities more attractive, drawing funds away from REITs and lowering their share prices.

Property Taxes. REITs must pay property taxes, which can make up as much as 25% of total operating expenses. State and municipal authorities could increase property taxes to make up for budget shortfalls, reducing cash flows to shareholders.

Tax Rates. One of the downsides to the high yield of REITs is that taxes are due on dividends, and the tax rates are typically higher than the 15% most dividends are currently taxed at. This is because a large chunk of a REIT's dividends (typically about three quarters, though it varies widely by REIT) is considered ordinary income, which is usually taxed at a higher rate.

Benefits of MLPs

In recent years, many U.S. energy firms have reorganized their slow-growing, yet stable businesses, such as pipelines and storage terminals, into master limited partnerships, or MLPs. There are some important differences between buying shares of a corporation and buying a stake in an MLP. With MLPs, investors buy units of the partnership, rather than shares of stock, and are referred to as "unitholders."

There are two classes of MLP owner: general partners and limited partners. General partners manage the day-to-day operations of the partnership. An MLP technically has no employees, so all services, from management to bookkeeping, are provided by the general partner. All other investors are limited partners and have no involvement in the partnership's operations. Limited-partner units are publicly traded, while general-partner units usually are not. The general partner stake is often 2% of the partnership, though the general partner can also own limited-partner units to increase its percentage of ownership.

Companies that use the MLP format tend to operate in very stable, slow-growing industries, such as pipelines. These types of firms usually offer dim prospects for unit price appreciation, but the stability of the industries that use the MLP format means below-average risk for investors. Cash distributions usually stay relatively steady over time (growing at little more than overall inflation), causing MLP units to trade somewhat like bonds, rising when interest rates fall and vice versa.

Some benefits of MLPs include:

High Yield. Most MLPs offer very attractive yields, generally falling in the 6%-7% range.

Consistent Distributions Over Time. The businesses operated as MLPs tend to be very stable and produce consistent cash flows year after year, making the cash distributions on MLP units very predictable.

Capital Gains. Firms primarily switch to the MLP structure to avoid taxes. While shareholders in a corporation face double taxation--paying taxes first at the corporate level, and then at the personal level when those earnings are received as dividends--owners of a partnership are taxed only once: when they receive distributions. There is no partnership equivalent of corporate income tax. Cash distributions to owners often exceed partnership income, and when they do, the difference is counted as a return of capital to the limited partner and taxed at the capital gains rate when the unitholder sells. Not only are capital gains deferred until an owner decides to sell, but capital gains tax rates are lower than income tax rates. In fact, we're particularly fond of pipeline MLPs, which have ample growth opportunities thanks to shifting sources of supplies of crude oil and natural gas. However, unlike other energy companies, MLPs tend not to take on commodity exposures, reducing risk and cash flow volatility. With distributions typically yielding 6-8% (and growing by 5-10% annually) and offering the opportunity for capital gains, MLPs could provide a compelling total return to investors.

Lower Cost of Capital. The absence of taxes at the company level gives MLPs a lower cost of capital than is typically available to corporations, allowing the MLPs to pursue projects that might not be feasible for a taxable entity.

General Partner Compensation Aligned with Limited Partners' Interest. Most general partners are paid on a sliding scale, receiving a greater share of each dollar of cash flow as the limited partners' cash distributions rise, giving the general partner an incentive to increase limited-partner distributions.

Drawbacks of MLPs

Investors should also consider the downsides to MLPs, which include:

Personal Tax Liability. Each unitholder is responsible for paying his or her share of the partnership's income taxes, which can make filing taxes more complicated. This is particularly true for larger unitholders, who may have to pay taxes in the various states in which the partnership operates. Moreover, limited partners might owe taxes on partnership income even if the units are held in a retirement account.

Limited Pool of Investors. MLPs face a smaller pool of potential investors than traditional equities because institutional investors, such as pension funds, are not allowed to hold MLP units without incurring tax liability. These large investors do not ordinarily pay taxes, so they tend to shy away from MLPs.

Institutional investors represent the majority of investor dollars in the market, so eliminating them reduces the potential demand for MLP units. Congress recently approved a provision allowing mutual funds to buy MLPs, which should dramatically increase the number of potential investors.

Benefits of Royalty Trusts

Royalty trusts, like MLPs, generally invest in energy sector assets. Unlike the steady cash flows at MLPs, royalty trusts generate income from the production of natural resources such as coal, oil, and natural gas. These cash flows are subject to swings in commodity prices and production levels, which can cause them to be very inconsistent from year to year. The trusts have no physical operations of their own and have no management or employees. Rather, they are merely financing vehicles that are run by banks, and they trade like stocks. Other companies mine the resources and pay royalties on those resources to the trust. For example, Burlington Resources, an oil exploration and production company, is the operator for the assets that the largest U.S. royalty trust, San Juan Basin Royalty Trust (SJT), owns the royalties on.

Royalty trusts end up on most investors' radar screens because of the incredibly high yields some of them offer, many in excess of 10%. In a low-interest-rate environment, it's easy to understand why such an income-producing investment might be garnering more attention.

Many of the positive and negative attributes of owning a royalty trust are similar to those faced by MLP unitholders. The benefits are:

High Yield. Trusts are required to pay out essentially all of their cash flow as distributions. Because of this, nearly all royalty trusts have above-average yields, many wildly above average.

Tax-Advantaged Yield. Due to depreciation and depletion, distributions from most trusts are not considered income in the eyes of the IRS. Rather, these nonincome distributions are used to reduce an owner's cost basis in the stock, which is then taxed at the lower capital gains rate and is deferred until an owner sells.

No Corporate Income Tax. Trusts are merely "pass-through" investment vehicles. The issues surrounding double taxation of dividends do not apply.

Peculiar Tax Credits. Have you ever received a tax credit for producing fuels from nonconventional sources? If you own a royalty trust, you might qualify for such credits. The laws on this issue are in flux, and the credits are generally small, but it's still a nice potential perk.

"Pure" Bets on Commodities. Want to bet on the future price appreciation of natural gas but don't want to get involved with the futures market? An excellent way to do that would be to buy a royalty trust that owns gas. The value of any given trust and the distributions it pays are directly tied to the prices of the underlying commodity. Just remember the sword cuts both ways here. The trust's income (and therefore probably the trust's stock price) could end up falling if commodity prices go down instead of up.

Drawbacks of Royalty Trusts

The downsides to royalty trusts include the following:

Depletion, Depletion, Depletion. Royalty trusts own royalties on a finite amount of resources. Once those resources are gone, they're gone. As the resources deplete, royalties and distributions will fall and will, eventually, go to zero. In financial terms, there is no terminal value. Granted, most trusts won't hit this point for two or three decades (or more), but it's still incredibly important to consider that distributions will eventually contract and disappear.

Volatile Distributions. Trusts typically pay out their distributions on a quarterly or monthly basis. If royalties fall in that period due to the underlying commodity price tanking, distributions will also fall. It's entirely conceivable that a trust that yielded 15% in the last 12 months could yield 3% in the next 12.

Tax-Filing Complexity. Owners of royalty trusts are required to report the pro rata portion of a trust's total income and expenses on their tax returns. This typically means filing Schedules E and B as well as having additional work with Form 1040.

State Income Taxes. Owners of trusts are liable for paying income taxes in the states in which the trust generates its royalties. Different states have different thresholds for when taxes have to actually be filed and paid, and the likelihood of owing income tax in multiple states increases with the size of a given ownership position.

The Bottom Line

Though they require a bit of work to understand and may increase tax complexity, investing in REITs, MLPs, and royalty trusts can boost the income-producing power of most portfolios.

Quiz 503There is only one correct answer
to each question.

1

Which of the following is not an advantage of each of the unconventional equities discussed in this chapter?

a.

Company tax advantages.

b.

High yields.

c.

Stable cash flows.

2

Which of the following is true regarding the tax treatment of MLPs?

a.

All taxes are deferred until the units are sold.

b.

The owner might have to file tax returns in the states where the partnership operates.

c.

MLP unitholders pay regular income tax on the full amount of any cash distributions received during the year.

3

Which type of security provides the most exposure to commodity markets?